Brief Relief for Dexia and European Banking Sector

By Margot Patrick

EPA

Within just a couple of days, investors have moved on from speculating about which bank might be next to fail after Dexia, and are instead taking comfort that the European Union may finally be getting its act together to recapitalize banks and restore confidence.

As recently as Tuesday, Dexia was being heralded as the first in a series of banking dominoes. Now, a plan by the French and Belgian governments to carve it into a good and bad bank and sell some units seems to have cheered everyone but private shareholders, who may still be wiped out.

European bank shares have rallied about 8% in two days, mainly because German Chancellor Angela Merkel indicated she is open to discussing much-needed E.U.-wide efforts to provide new rounds of state aid and organize bank recapitalizations. Expectations of further support to the flagging global economy from central banks including the U.S. Federal Reserve have also revived investors’ hopes.

But it all looks like a short relief rally. Banks that are in no shape to handle larger and ever-more-likely losses on their Greek sovereign bond holdings. Also, only some of the structural problems of 2008 have been adequately sorted out.

Dexia’s overwhelming reliance on wholesale funding, particularly in the U.S., may be the extreme, but plenty of European banks are facing the same funding challenges on a smaller scale. Covered bonds backed by residential mortgages and repo financing lines are still being tapped by banks for funding, but they will need either a re-opening of the broader credit markets or longer-term liquidity facilities from central banks to keep going through next year.

The ECB later Thursday will make a rate decision that some expect will mean a 25 or 50 basis-point cut. There’s also the chance the central bank will announce a one-year financing operation that would give banks a backstop against their debt maturing next year.

What’s apparent is that policy makers must move quickly to keep investors in financial markets on board with their new-found optimism. Otherwise the next domino will quickly become the focus and fears of contagion will again take front and center in investors’ minds.

“More bank capital is good, but solving the sovereign debt crisis would go a long way in improving the outlook for Europe’s banks,” said Gary Jenkins, fixed-income analyst at Evolution Securities.

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